Memeorandum

September 22, 2008

End The Madness

Because greater opacity will gull lenders into pitching their money into black holes - Ramesh Ponnuru urges a suspension of mark-to-market accounting for some assets. I rank that alongside the ban on short-selling as examples of solving the problem by shooting the messenger.

Comments

Tom, I mostly agree, but I wonder if we're not evaluating "market" too often. As we've been discussing, in a situation like we've got right now, the liquidation value of a long term asset today may not be the value it would have in a perfectly efficient market. Does it make sense then to force mark to market in the absence of complete information?

I have to disagree with TM. Especially when marking to market forces the holder to take actions such as liquidating other assets or raising capital in order to maintain it's capital ratio. This is not just a matter of providing information; as I understand it the rules require institutions to respond to the markdowns as if they are genuine fundamental revaluations, which can lead to a vicious circle of forced sales and additional markdowns.

Marking to market is a blunt instrument but a necessary one. If firms are going to play the leverage game and invest in dodgy instruments, mark to market imposes a degree of discipline. If firms want to restructure into entities taking traditional deposits and making more traditional loans (as Morgan Stanley and Goldman are considering doing), they can probably avoid mark to market.

I respect the opinion of those arguing against mark to market. But I think many of the anti-M to M folks are exaggerating their case. To read some of these articles, one would think that firms are being laid low because other firms are making isolated sales at a discount of otherwise solid securities, and the firms in good shape are being forced to mark to market. I think that is a small part of the picture. The larger part is making loans in an environment were folks thought real estate values would go up and never come down.

What needs to be repealed is not mark to market, but human greed and stupidity. Unfortunately, there is no repeal of human greed and stupidity on the horizon.

The big financial party is over, and we are dealing with the hangover. Let's just hope the large doses of Advil don't kill the patient.

To read some of these articles, one would think that firms are being laid low because other firms are making isolated sales at a discount of otherwise solid securities, and the firms in good shape are being forced to mark to market.

That's a bit of a straw man. No one's saying that m-t-m is the cause, just that it's drastically exacerbating the problem.

John Mauldin makes a similar point to the one in TM's linked article:

"The current mark to market rule, while nice in theory, works in normal times. But it has the unintended consequence of making things worse in crisis times. Why should an institution have to write down a security which over time is going to pay back the lion's share or more of its value just because a severely stressed institution was forced to sell that security at a very low price in a time of crisis?

"Yes, there needs to be transparency and we as investors need to know what is on the books of the companies that we invest in. But it is somewhat like my bank asking me to mark to market my home and pricing my loan daily based on that new price. If my neighbor loses his job and sells his home at auction, does that mean my home is now worth less two years from now. Maybe an even better analogy, if I am renting that home to a very good tenant, does my neighbor's price impair my income?

"I was, and am, a fan of mark to market pricing. But we need to think through what a market price is. Not all things can be easily marked to market. This is doubly true when "market price" is a nebulous index of mortgage securities which may or not have a fundamental relationship with an illiquid security on the books of an institution which has no intention of selling, especially in a time of credit crisis."

Jimmyk, I appreciate the point about M2M exacerbating the situation. But what happens if we end M2M? Will there be a realistic look at what are the expected losses from the various tranches of securitized debt that might be valued at par absent M2M? I doubt it.

I also understand that I might reasonably be accused of using a straw man argument. On the other hand, when I read these financial meltdown articles, it seems as if there are many straws being thrown into the wind (whether those straws are M2M or short selling).

Newt:
"First, suspend the mark-to-market rule which is insanely driving companies to unnecessary bankruptcy. If short selling can be suspended on 799 stocks (an arbitrary number and a warning of the rule by bureaucrats which is coming under the Paulson plan), the mark-to-market rule can be suspended for six months and then replaced with a more accurate three year rolling average mark-to-market."
LUN

Jimmyk, if we suspend M2M, don't you think that the reckoning will simply be drawn out? Don't you think that the projected default rates on securitized debt will not be adjusted upward, and that firms' financial health would be overstated?

I don't claim that there any any easy answers, and I realize that phrases such as "it's time to face the music" may be derided as talking points. But it really may be time to face the music.

By the way, I have a personal interest in this being papered over for another few years so I can get all my kids out of college (after I have done that, I won't mind walking the streets of Boston with a tin cup; maybe Jane will stroll by on occasion and drop a few quarters in the cup so I can go to Starbucks). So maybe a three year M2M suspension would be to my personal benefit. But I really think that, unless an M2M suspension is combined with a hard look at reasonably expected defaults, such a suspension would be the equivalent of putting off getting out the lifeboat on the ground that the Titanic is only leaking from one side.

I have a personal interest in this being papered over for another few years

You're assuming the answer to your question. The issue is whether "market" is an accurate assessment of the assets values. In normal times it would be. The whole premise of the argument for suspending m2m is that "market" is misleading. If that's the case, then suspending m2m wouldn't be "papering over," it would be presenting a more accurate picture. You may disagree with the premise, but that's the case you have to make.

But if I had to make that case, jimmyk, wouldn't you have to make the case about current book values accurately reflecting default rates in light of what has happened to real estate?

I don't view M2M as a sacrosanct valuation method. Arguably, M2M is only appropriate for an entity closer to the dealer end of the passive investor/freewheeling dealer spectrum. My concern is that suspending M2M without looking closely at repayment expectations really is "papering over" the problem.

I am going to try to find sites that discuss whether reasonably expected default rates are built into financial asset valuation absent M2M. If I am lucky, by the time I find those sites, this crisis will be over.

US military officials may have taken credit where none is due for decreasing violence in Baghdad with their troop surge of February 2007, data from satellite imaging suggests.

By comparing the amount of light produced at night in different areas of the capital before, during and after the 30,000 extra troops had been deployed, researchers from UCLA were able to track the movements of the warring Sunni and Shiite factions.

I have a general idea for avoiding future liquidity contagion problems with derivative securities, but I'm not sure it's practical. What I was thinking is that securities could have "crisis" or "system failure" clauses. These would be restrictions on how much lenders (in a broad sense) would be paid conditional on some market-wide, non-manipulable indicator of a crisis (spreads over Treasury, perhaps, or volumes of cash withdrawals from predesignated banks and mutual funds, or...?).

These clauses could be set up to give the lender an option--"If spreads over Treasury go over x points and you call your bond or ask for more collateral or whatever, you only get y% of the face value you are owed." (Perhaps this could be enhanced with an encouragement such as "If spreads go over x points and you DON'T withdraw your liquidity at the crucial moment then you get 1+z times your money when the crisis is past.") These haircut percentages could possibly be made nonlinear in the degree of crisis so that their deterrent effect was highest when the panic was greatest.

The idea is to create a counter-incentive to panic by penalizing withdrawals of liquidity that occur just when liquidity is most needed by the system. And if I see that everyone else is facing the same incentives, my own level of panic that everyone else is pulling their money out is reduced and a virtuous cycle is created.

Another way to look at it is that systemwide liquidity risk cannot truly be hedged or insured, yet current contracts (and valuation methods) don't account for this. Everyone getting their money out at the same time is always going to be impossible no matter how we regulate, as long as we have some version of borrowing short and lending long (and I kind of like modern civilization). If everyone agreed (or were required) to only do business with borrowers who included such "crisis-haircut" clauses in all their securities, perhaps liquidity contagions would be less likely and the system more robust.

I welcome any comments about whether this idea makes sense or how it could be implemented or if we already have such things but they somehow don't work. Note that any crisis indicator must be non-manipulable by an individual entity--otherwise they could use manipulation to avoid paying people whenever they felt like it, and no one would do business on that basis.

JMH, that's quite a find. The UCLA guys looked at four images, each depicting light at a resolution of 3 sq mi blocks, and managed to determine that the political party they all vote against is wrong about everything. What they don't manage to answer is how the Shia area stayed so bright, since we all know there's been no electricity in Baghdad since the happy days of 2002. Right? Their hypothesis for the Sunni areas going dark is that the population fled to Jordan and Syria. It would seem a simple matter to get satellite images of Amman and Damascus and track the light changes, but I guess looking at four pictures is as much as any two phd's should have to do.

If you hold $1MM in mortgages and they generate a monthly income of $10,000, and no one will buy them, what is the market? Is it zero? The net present value of the cash flow?

I hesitate to advocate opacity, but currently there is no market, as in no buyers. Absent a market of buyers, is an alternative valuation based of the net present value of the cashflow at a pessimistic imputed interest rate (say 150% of the actual current rate) and a pessimistic default rate (say the same 150%)acceptable?

MTM assumes everything is sold daily. Is that any more transparent when there is a thin to absent market?